The Fed’s message that rates will be on hold “for some time” clashes with rate cut bets in 2023

(Bloomberg) – Federal Reserve Chair Jerome Powell has history on his side as he and his colleagues split from Wall Street over how long interest rates will stay high in 2023.

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After the fastest tightening of monetary policy since the 1980s, the central bank looks set to cut interest rates by 50 basis points on Wednesday after making four straight moves of 75 basis points to curb inflation.

Such a move — widely flagged by officials — would lift interest rates to a target range of 4.25% to 4.5%, the highest level since 2007. They are also likely to tighten further by 50 next year, according to economists polled by Bloomberg Basis points signal , and the expectation that once they reach that peak, they will remain on hold throughout 2023.

Financial markets agree with the short-term vision but see a rapid fall from peak interest rates later next year. That clash could come as investors expect price pressures to ease faster than the Fed, which fears inflation will prove sticky after being burned by a poor forecast that would be temporary. It could also reflect bets that rising unemployment will become a bigger concern for the Fed.

This week’s meeting in Washington is a fresh opportunity for Powell to underscore his point that officials expect to keep interest rates high to curb inflation — as he did in a Nov. 30 speech when he stressed that the policy will remain restrictive “for some time”.

Over the past five interest rate cycles, the average holding period at a top rate has been 11 months, and these have been periods when inflation has been more stable.

“The Fed has sent out the message that the federal funds rate is likely to remain at its peak for a while longer,” said Conrad DeQuadros, senior economic advisor at Brean Capital LLC. “That’s the part of the message that the market has consistently failed to get. Estimates of how much inflation will fall are overly optimistic.”

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At play in the tension between the Fed’s communications and investors are two different visions of the post-pandemic economy: the markets’ view of a credible central bank that is fast moving inflation towards its 2% target, possibly with the help of a mild recession or disinflationary forces that kept prices low for two decades.

Financial markets are “just pricing in a normal business cycle,” said Scott Thiel, chief fixed income strategist at BlackRock Inc, the world’s largest money manager.

A competing view holds that supply shortages will be an inflationary force for months and perhaps years as newly drawn supply lines and geopolitics affect critical inputs from chips and labor to oil and other commodities.

In this thesis, central banks will be wary of advances in inflation, which may be temporary and vulnerable to the emergence of new frictions leading to sustained price pressures.

“Strategic competition” is inflationary, says Thiel. “We expect inflation to be more persistent, but also expect inflation volatility and broader economic data to be higher.”

Swap traders are currently betting that the overnight rate will peak at just under 5% in the May-June period, with a full quarter point cut by around November and the federal funds rate ending next year at around 4.5% .

That would be an unusually quick declaration of victory over inflation, which is now three times the Fed’s 2% target.

“The futures curve is a manifestation of the success or failure of the FOMC’s communications policy,” said John Roberts, the former chief macro modeler to the Fed board who now blogs and consults with investment managers, referring to the Federal Open Market Committee.

It is also not only the timing for the cuts to begin, but also how much money market traders see coming that are beyond historical norms. The more than 200 basis points of pending Fed rate cuts now priced into futures markets are the longest before any policy easing cycle, dating back to 1989, according to Citigroup Inc.

According to Bloomberg data, futures contracts imply a Fed rate cut ending around mid-2025.

Fed officials have not completely ruled out a rapid deceleration in inflation. John Williams, the president of the New York Fed, said he expects inflation to halve to around 3% to 3.5% next year.

Commodity price inflation has started to cool and falling rates for new home leases should eventually lead to lower reported housing costs. Prices for services minus energy and housing, a benchmark highlighted by Powell in a recent speech, slowed in October.

Investors are also optimistic about the price pressure. Inflation swaps and inflation-linked government bond prices assume that consumer prices will fall sharply next year.

But there are also signs that the road back to the Fed’s 2% target could be long and bumpy.

Employers added 272,000 jobs monthly over the past three months. That’s slower than the average of 374,000 over the past three months, but it’s still resilient and one reason demand is holding up.

Fed officials note that inflation historically has a sticky quality, meaning it takes a long time to squeeze out of the millions of pricing decisions that businesses and households make each day.

They also measure policy implementation by securing 2% inflation, not 3%, and may be reluctant to lower borrowing costs if inflation remains stuck above their target.

Williams, for example, said he doesn’t expect the reference rate to be cut until 2024, although he expects inflation measures to fall next year.

“People like to focus on getting things back to where they were. But the trend of “higher interest rates” “may continue for quite a while,” said Kathryn Kaminski, chief research strategist and portfolio manager at AlphaSimplex Group. “People underestimate that.”

–Assisted by Alex Tanzi and Simon White.

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